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Custodial Accounts for Minors - which is right for you?

As parents we want our children to experience financial security and often we establish accounts for them to help get them started. The most common types of accounts we establish are UGMA, UTMA and 529 college savings plans. Others are fortunate enough to establish some kind of brokerage account to help their children on the path to investing and providing for their future. For the purposes of this discussion, we will focus on these 3.

For starters, it is important to understand the general particulars of UTMA and UGMA accounts. These are both types of custodial accounts, NOT guardian accounts. Both have no contribution limits however, the donor must be aware of how larger gifts affect their annual gift tax and lifetime estate tax exclusions. An important note relating to these accounts - these accounts can impact financial aid eligibility. Custodial accounts are considered an asset of the child and is counted against financial aid. Approximately 20% of these assets will be expected to be used toward funding a student's education in any given year.

UGMA stands for Uniform Gift to Minors Act, UTMA is Uniform Transfer to Minors Act. For both, the parent or grandparent is the official custodian who donates assets and manages the account on behalf of the minor. The custodian must be financially sound and a beneficiary is required to be a US Citizen or permanent resident with a social security number. The account is in the minor's name with the custodian responsible for overseeing or running it. The Uniform Transfers to Minors Act, is the modernized law that has replaced the earlier Uniform Gifts to Minors Act in almost all states.

These accounts are taxed to the child for interest, gains or dividends, and have no restrictions on withdrawals for the parent although they cannot be legally closed by the parent. Previously these transfers could save the donor on taxes because one could move investment income out of a higher bracket into the kid’s low bracket. The federal kiddie tax, recently expanded to cover students through the age of 23, puts investment income, above small amounts, into the parents’ tax bracket. To escape the rule a student has to do one of three things: cover more than half his living costs with earned income, turn 24 or file a joint return with a spouse. All unused money must be distributed by the time the child reaches the maximum age allowed for custodial accounts as dictated by their state.

Termination age for these accounts can vary from state to state but generally speaking the UGMA termination age is 18 whereas the UTMA termination age is 21. UTMA funds must be used for the benefit of the beneficiary. The UGMA account permits a parent to donate gifts to the child such as money, life insurance, stocks or annuities. it generally has stricter rules and will only permit basic assets to donate. The UTMA account however, allows more time for control and will also allow investments in more assets than with the UGMA account. Again, depending on the state where it is opened, maturity age could be as high as 25. This is useful to parents who may believe their minor is not financially responsible and could misuse or overspend the money.

A 529 Plan is an education savings plan operated by a state or education institution designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Code which created these types of savings plans in 1996. 529 Plans can be used to meet costs of qualified colleges nationwide. In most plans, your choice of school is not affected by the state your 529 is from. You can be a California resident, invest in a Colorado plan and send your child to collect in Virginia. Although contributions are not deductible, earnings in a 529 plan grow federal tax-free and will not be taxed when the money is taken out to pay for college. In addition to the federal tax savings, over 30 states currently offer a full or partial tax deduction or credit for 529 plan contributions.

With few exceptions, the named beneficiary has no legal rights to the funds in the 529 so you can be assured the money will be used for its intended purpose. This differs from custodial accounts under UGMA/UTMA, where the child takes control of the assets once he or she reaches legal age. A 529 account owner can withdraw funds at any time for any reason - but the earnings portion of non-qualified withdrawals will incur income tax and an additional 10% penalty tax. Most plans allow you to "set it and forget it" with automatic investments that link to your bank account or payroll deduction plans. Deposits to a 529 plan up to $14,000 per individual per year ($28,000 for married couples filing jointly) will qualify for the annual gift tax exclusion. You can change your 529 plan investment options twice per calendar year and rollover your funds into another 529 plan one time in a 12-month period. There is no federal limit on the frequency of these changes if you replace the account beneficiary with another qualifying family member at the same time. 529 plans have no income limits, age limits or annual contribution limits. There are lifetime contribution limits and they vary by plan.

It is important to consider how a 529 will affect financial aid because it WILL. Each school can (and most will) set its own rules when handing out its own need-based scholarships, and many schools are starting to adjust awards when they discover 529 accounts in the family. Also consider that the federal financial aid rules are subject to frequent change. Finally, remember that most financial aid comes in the form of loans, not grants, and so you end up paying it back anyway.

Which is the right solution for you? A CFP or other certified professional can review your financial position as a whole and offer recommendations. It is always best to work with someone you are comfortable with to determine what the optimum path for you is.

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